Inside the Term-Sheet Mindset of a Life Sciences VC

Arthur Klausner, AM Pappas & Associates

VCs call their stock "preferred" for a reason.

There's nothing funnier than a venture capitalist in a comic strip, right? And of all the VC-focused strips out there, there's nobody funnier than "Dogbert the VC" from Dilbert. In one of my all-time favorite panels of this (admittedly brief) series, Dogbert dismissively tells the wide-eyed technology inventor: "you'll get 100% of the special decorative non-equity stock. I'll settle for all the common stock."

Well, I hate to say it, but Scott Adams got the details wrong-although he was indeed pretty much on the right track when it comes to the overall concept. In reality, VCs almost always purchase convertible preferred stock, while entrepreneurs and management get common stock and/or options on common stock. And whether those common shares ultimately turn out to be of the infamous "decorative" variety depends entirely on the company's outcome. This article focuses on the drawbacks-and also the benefits-of common stock.

Defining the Terms: Common, Options, and Preferred

Privately held companies often issue different types of equity securities as a way to distinguish between various shareholders and to potentially treat these classes differently as future events unfold.

Common stock is the standard unit of equity in a company, with each share entitling its owner to one shareholder vote. While common shareholders can be considered the "owners" of a company, they are actually last in line when it comes to dividing up the proceeds if the company were to be sold. Specifically, secured lenders, then unsecured lenders (including trade creditors), then convertible debt instruments, then preferred shareholders (in whatever order their stock purchase documents dictate), and finally common shareholders receive payment. Put another way, common shareholders receive the residual amount after all the other groups have been discharged in full. The advantage of being last in line, however, is that common shareholders have unlimited upside if the company turns out to be extremely valuable.

Stock options entitle the holder to purchase a specified number of shares of common stock at an agreed upon price. The beauty of this arrangement is that it allows the holders to lock in today's price, yet it provides the highly valuable flexibility to consummate this purchase at any time during the option's life (usually set at 10 years).

Convertible preferred stock ("preferred") has various preferential rights over common, usually including antidilution protection, liquidation preference, dividends, and certain voting rights. Indeed, the beneficial features of preferred stock are limited by little other than the imagination of the document drafters. Importantly, preferred stock is almost always convertible into common, meaning that holders can decide at the very last moment whether they wish to be treated more like lenders (i.e., relying on the protective provisions of the preferred) or as shareholders (by converting into common). And, in many cases, the terms of the preferred stock allow the investors the best of both worlds.

Why do private equity investors typically get to own a "better" class of shares than do management/employees who are putting their lives' work into the company? The answer is simply the Golden Rule: he (or she) who has the gold, rules. That being said, the key advantage to common stock (or options on common stock) cannot be understated: The purchase price of common stock in a privately held company is generally significantly less than that for preferred (with discounts ranging from 90% or more at the early stages of a company to perhaps 10% close to a projected initial public offering).

In many outcomes, the preferred and common stock end up being treated very much the same. If a company goes public, for example, the preferred stock converts directly into common. On the other hand, if a company goes bankrupt there is usually little or no money remaining after paying off the creditors to be distributed to either preferred or common. But in between these two extremes, the preferred and common do indeed receive differential treatment.

And the Survey Says....

In a recent survey of over 200 private life sciences financings completed during the past 12 months, VC Experts Inc. found preferred stock to be the security of choice in 86% of biopharmaceutical deals and 98% of medical device financings. (See Exhibit 1.) The paucity of common stock deals for medical device companies in the survey is actually somewhat surprising, as angel investors are more likely than VCs to accept common stock in return for their money. Because medical devices often require relatively small amounts of capital to become operational and demonstrate basic proof-of-principle, these start-ups represent highly appropriate investment opportunities for angels (who usually do not have the deep pockets associated with institutional venture capitalists). From management's perspective, the key advantage of having investors purchase common stock is that employees own exactly the same type of equity as do the investors, and hence both groups of shareholders are treated the same when it comes time to divide the pie. The problem, however, is that this parity eliminates the ability of the company to offer enticingly low-priced stock options to its employees and consultants.

In contrast, fewer biopharmas receive angel financing, largely due to the significant amounts of capital required to get these operations up and running (not to mention their often staggeringly large anticipated capital needs going forward). This means that their capital structures almost always consist of founders/employees owning common stock/options and VCs owning preferred-and the ability to issue low-priced stock options is preserved.

If one compares the number of stock options that might be required to recruit top management in a common-only medical device company versus a firm with both common and preferred stock, the company that is unable to offer low-priced options may have to provide a greater number of high-priced options in order to make the compensation package equivalent. Hence a hidden cost of the common-only structure.

Tricks of the VC Trade (a.k.a. "We're no angels")

As life sciences company employees are keenly aware, the typical vesting period for stock options is four years (most often with the first 25% of the option grant vesting at a one-year "cliff" and the rest vesting monthly over the remaining 36 months). Option holders generally recognize ordinary compensation income when they exercise their options (i.e., they owe tax on the difference between their exercise price and the current fair market value of the stock).

Often private company option holders have the ability (known as an 83B election) to exercise their options immediately and thereby purchase "restricted shares," with the company having a gradually lapsing right to buy back the shares for the price originally paid in quantities that mirror the original vesting schedule ("reverse vesting"). Why would someone want to pay up front for shares when they are still subject to repurchase? First, taking this action before the value of the shares has changed sets the individual's cost basis at the price being paid (fair market value) and means that the individual has no tax liability until he or she actually sells the stock. Although this may seem like a minor point, some unfortunate executives have exercised low-priced options on high-flying biotech stocks (thereby immediately generating taxable, ordinary income) but have then ridden the stock down as the company (or overall markets) collapsed. Sadly, the fact that the stock no longer has its previous value does not eliminate the previous tax burden.

The second key attribute of an 83B election is that the action effectively starts the one-year clock on (what will hopefully be) long-term capital gains. Once stock is owned for a year, the tax liability on price appreciation drops from the rate on ordinary income (up to 35%) to the capital gain rate of 15%.

What's the disadvantage of purchasing your stock up front and/or making an 83B election? Most importantly, if the company goes out of business you'll very likely lose the entire purchase price that you had laid out. In the good old days, companies often provided forgivable loans to top executives in order to cover the purchase price of their stock, but this have-your-cake-and-eat-it-too possibility has for all intents and purposes been eliminated in this post Sarbanes-Oxley world.

When founders set up a new company, they almost always purchase their entire common share holdings up front (usually at a very low, "nominal" price per share). After all, why subject yourself to a vesting schedule if you don't have to? Venture capitalists are rightfully concerned about this approach, however, because it eliminates the concept of early employees "earning" their options via continuing and valuable service to the company. As a result, part of the negotiation over the first round of institutional financing often involves convincing the entrepreneur to convert his/her common stock into restricted stock subject to repurchase by the company over four years. While this can indeed be a significant give-up on the part of the founder(s), it's tough to argue that it's not a good outcome for the company. (Then again, Bill Gates stopped accepting new options from Microsoft years ago, and it doesn't seem to have dampened his enthusiasm for working there.) At any rate, a reasonable compromise in this situation is for the VCs to allow the entrepreneur to keep a portion of his/her stock-often related to how long the individual has actually been working with the company-and have the rest be subject to a standard vesting/repurchase schedule.

One further aspect of the preferred/common stock structure bears mentioning. If a company runs into trouble and a low-priced financing becomes necessary, the common stock will get severely diluted via the large influx of new shares. In contrast, preferred shareholders are cushioned at least to a certain extent by their anti-dilution protection. Current management, consultants, and employees usually receive new option grants at this point in order to build back their positions and to re-incentivize their going-forward performance. Discussion here can become a little testy, however, if these individuals expect to be "made whole," as VCs usually feel it appropriate for current employees to feel at least some of the pain of the down round.

The longer that a company founder remains in a deal, the greater the potential for dilution. Even if there is no significant down round, a series of flat or even slightly up rounds can significantly eat into a founder's percentage ownership - especially if he or she is not directly involved in the company and would not typically have their ownership position replenished over time. With specialty pharmaceutical companies, the main issue involves the huge quantities of funds these companies typically raise in rapid fashion prior to a public offering or acquisition. For biotechs, this condition can be exacerbated by the addition of a lengthy time frame. As for medical device companies, the (relatively) small amounts of capital required plus the (relatively) short time frames involved make this the best situation for at-risk founding shareholders. That said, if development doesn't go as planned and more capital is required than was originally projected, any non-contributing medical device company founders run the double risk of dilution combined with typically modest exit valuations.

An important issue arises at this point, however, regarding any common stock that had been provided to the source of the company's technology (most often an academic institution, but increasingly a drug or biotech company). If the technology itself has failed, then having the contributor of the technology suffer a washout makes sense; but if the company's difficulties were not caused by technological shortcomings, then the source institution can end up being punished rather unfairly. Start-up life sciences companies and their early venture capital backers may (correctly) argue during in-licensing negotiations that accepting equity instead of cash for technology rights can provide a faster return for the licenser than waiting for milestone payments and ultimately royalties on product sales. But the VCs certainly don't stress the dirty little secret that the institution's equity holding can become severely diluted if even a single down round occurs anytime during the company's financing history.

Take-Home Message

When an entrepreneur chooses to accept venture capital funding, he or she needs to be prepared to also accept both the benefits and the drawbacks that these so-called professional, value-added investors bring. While important potential VC attributes such as sound business advice, a well-tuned rolodex, and easier access to additional funding should line up solidly in the plus column, one of the drawbacks from management's perspective is the VC's almost universal insistence on using a preferred stock vehicle. In all but the rarest of cases this deal point is non-negotiable and should be considered part of the price of admission into the wonderful world of venture financing.

More flexibility regarding the form of investment is often available when dealing with less sophisticated angels investors or potentially nave "friends-and-family" financial backers. While the temptation on the part of founders may be to steer these investors into plain vanilla common stock, providing some sort of preferred vehicle does have several advantages. First, it allows employee options to be priced at a discount to the investors' stock, thereby assisting in recruitment. Second, creating differentiating features between the various classes of shareholders can prove useful should difficulties arise and a recapitalization become required. And finally-at least as far as friends-and-family investors are concerned-issuing a form of preferred stock can avoid generating a lot of unpleasant tension at those large Thanksgiving dinners.

Arthur Klausner is currently a venture partner at AM Pappas & Associates, and he is a former general partner of Domain Associates LLC. E-mail any comments directly to aklausner@ampappas.com. The author thanks Michael Sanders of Reed Smith LLP for his counsel and perspective.

This article previously appeared in the June 2005 issue of START-UP Magazine, copyright 2005, Windhover Information Inc., and has been re-printed with permission.